by Arthur L. Fries, RHU
Executive Summary
A disability claim buyout involves a lump-sum dollar amount paid by the insurance company to a claimant in lieu of the continuation of a monthly benefit. Since a large sum of money may be involved, it is suggested that the claimant seek advice from an individual experienced in negotiating disability buyouts. This article discusses how a disability buyout works, along with the advantages and disadvantages that should be considered before a buyout decision is made.
As a financial planner you are asked to provide advice in many areas. Maybe a client has sought advice from you on a disability claim, where a disability insurance company is offering your client a settlement in the form of a buyout. Rather than pay a monthly benefit for what may be many years, the company offers a lump-sum settlement in the form of a single check. If your client agrees to the settlement, they surrender their disability policy to the insurance company, which then no longer pays a monthly benefit.
Is a buyout a good move for your client? This article covers the reasons to consider a buyout as well as the reasons to not consider a buyout. If your client decides to pursue an insurance company's buyout offer, you'll want to know how companies derive buyout figures and whether they're fair. And there's a decision you'll need to make: Can you manage the buyout process on your own, or should you bring in a consultant? This article shares some thoughts on things you should be aware of in working with consultants and actuaries, and how the buyout figures are calculated.
Reasons to Consider a Buyout
I often suggest that the claimant, after receiving a buyout offer, consult with his or her financial planner since the planner is the most likely to have a broad overview of the claimant's financial picture. There are many reasons to consider a buyout, all of which are unique to your client's situation from both an emotional and financial standpoint:
1. Tuition money is needed for college-age children and the
claimant's long-term goals have to be set aside to take care of
short-term obligations.
2. A financial investment may arise that may provide substantial
gains in the future and may not be available at a later date.
3. The claimant has a business or job opportunity that will use his
or her past skills and education and will not conflict with the
claimant's medical symptoms.
4. The claimant no longer has to deal with claim forms (progress
reports, attending physician statements), independent medical
evaluations, functional capacity evaluations, video surveillance,
field investigations, submission of tax returns and other documents
after a disability claim has been approved.
5. Your client's anxiety over knowing their claim my be
discontinued, because of harassment by the insurance company, can
be eliminated.
6. There is a change from one administrator of the claim to
another.
7. There is a change in the insurance company's claim management
philosophy or administrator, or a change in claims personnel.
8. It's possible that your client may die in the near future.
9. The claimant's health changes in a way that might increase
mortality, but this is not known by the insurance company.
10. There's a chance that the claimant might get better and be able
to return to work.
Disadvantages of a Buyout
There also are negative aspects of a buyout, where your client may be better off keeping their policy or policies in force, with the expectation that the monthly benefit will be paid for the duration of the benefit period. Following are some reasons to turn down a buyout:
1. Your client has a lifetime payout in their occupation and has
a family history of longevity.
2. Your client may squander the money in bad investments or bad
judgment, despite your best advice.
3. With a large lump sum, friends or relatives may jump out of the
woodwork to ask for money that should be used for long-term
investment purposes.
4. Your client may be tempted to gamble large amounts of cash on
horses, craps, poker, and so on, at the risk of losing it
all.
5. Your client is a day trader with high expectations and little
knowledge, and might end up in the market at the wrong time.
6. There may be emotional and economic devastation to your client
as a result of using this money in areas where they have no
financial expertise.
Working with Consultants and Actuaries
Your client, with your assistance, has decided to pursue the insurance company's buyout offer. But do you have the necessary experience to manage a disability claim buyout for your client? As you are well aware, giving advice in an area in which you are not proficient may be the basis of a malpractice suit. Maybe you have sold a few disability policies, sold many, or none at all. Maybe you're knowledgeable in the area of disability claims, or you've decided to bring in an expert instead.
You may find that handling this process on your own is difficult, so with the help of a consultant, you can lower your anxiety level—and you will find the fees reasonable. It would be wise to find a consultant who has handled many disability claims and is familiar with the disability buyout negotiation process. Even when a disability buyout is not in the best interest of your client, the consultant will get paid for his or her time, thus allowing your client to receive secure, objective advice.
There are disability claim consultants who can help you, and you needn't worry about losing your client to them. Those consultants with the most expertise advise only on claims and do not sell products or charge a fee for financial advice.
If possible, an actuary experienced in disability claims should be brought in to work up numbers for your client. Finding an actuary in this area may be difficult since those working for insurance companies usually are not available to claimants. But they can be found, and the right actuary can make a difference in the numbers. Some disability claim consultants have access to disability actuaries and can provide assistance either behind the scenes or work on your behalf, with the insurance company being aware of their presence.
Factors to Be Aware Of
Some disability companies provide an initial offer that is fair and based on sound actuarial principles, and they don't deviate from their initial offer. Others, however, may lowball the initial offer in hopes of paying the lowest possible figure. Some companies engage in questionable approaches that pressure or threaten the claimant in an attempt to make the claimant give in to the company's offer. These companies should be avoided, of course.
An insurance company may open by asking the claimant to provide a figure. How the claimant responds could be crucial in the buyout process, and the claimant should always secure an offer in writing.
In the offer letter, insurance companies will usually start out with the figure they are prepared to pay and then talk about the present value of anticipated future benefits. At this point the company also should mention the future potential benefit (that is, how much the monthly benefit will be worth to, say, age 65). The present value takes into consideration the insurance company's reserves, then a discount factor is applied that represents unearned interest for future years. A COLA (cost-of-living adjustment) benefit might be included in the policy. Make sure this is included in the insurance company's figures.
Whether the COLA benefit is paid on the basis of simple or compound interest should be specified. Almost all COLA benefits level out at age 65 and then, if it's a lifetime payout, continue at the level amount for life. On rare occasions, I've seen a COLA benefit that does not level out at age 65 and will continue to increase for life. In the case of residual (partial disability) benefits, which typically are paid to age 65, there is one company that pays the partial disability benefit for life (in a contract that pays total disability benefits for life).
After reducing the future potential benefit to the present value and applying an interest factor, an additional reduction is made for mortality (when the insurance company thinks you will die) and a morbidity factor (if the insurance company thinks you have a potential for coming back to work). Finally, a further discount is applied to give the insurance company a profit margin so that the buyout makes sense to them. The lower the offer, the higher the profit margin.
Sample Actuary Figures
Following are figures from an actuary related to a disability buyout I was involved in two years ago.
Claimant is disabled, due to carpal tunnel and cervical problems since August 1996. He was born December 1960. He has lifetime benefits with COLA to age 65. His original monthly benefit, before COLA, was $18,550.
Currently, aged 45, he has a life expectancy to age 79.2, according to recent Society of Actuaries' standard mortality tables. With COLA already applied, his current benefit is $25,228. COLA is related to CPI, has a 4 percent minimum increase and has been assumed to be 4 percent in the future. His maximum payout, including future 4 percent COLA increases, would be $14,383.240. If these benefits were received today, discounting at a 5.50 percent interest rate, the value would be reduced to $5,940,352, or 41.3 percent of his maximum anticipated payout. The reduction in value is significant because of his young age and long life expectancy.
An insurance company will hold reserves based on the 1987 Commissioner's Group Disability Table and is allowed to include additional morbidity factors. This reduces the value of benefits to $4,058,169, or 28.2 percent of his full payout. Again, this reduction reflects his young age which, according to the standardized insurance table, projects a chance of recovery from disability. That prognosis may or may not apply to this claimant.
Finally, an insurer might settle this liability for approximately 80 percent of the reserve, or $3,246,535, or 22.6 percent of his maximum payout.
Summary of financials:
- Monthly Benefit: $ 25,228
- Maximum payout, expected lifetime: $14,383,240; percentage of maximum payout: 100.0%
- With interest and mortality*: $ 5,940,352; percentage of maximum payout: 41.3%
- With interest and morbidity (i.e., reserve)** $ 4,058,169; percentage of maximum payout: 28.2%
- Possible settlement offer $ 3,246,535; percentage of maximum payout: 22.6%
*Society of Actuaries RP 2000 mortality table
**1987 Commissioner's Group Disability Table (CGDT)Percentage of
Maximum Payout
Conclusion
A disability claim buyout can provide additional funds for you as a financial planner to work with in meeting the long-term goals of your client. There certainly is an opportunity for new fees or commissions on your part. In the final analysis, it will be your objectivity that results in your keeping the client or getting referrals. Knowing where to go and giving your client options will enhance your overall credibility.
Arthur L. Fries, RHU, is a disability claim consultant. Although no longer active in selling, for many years he specialized in the sale of individual disability insurance to attorneys in the Los Angeles/Beverly Hills area of California. He is located in Newport Beach, California, and can be reached at (800) 567-1911 or www.afries.com.
